Key Idea: A country buys trainers from abroad, sells software abroad, its workers send wages home, and foreign firms build factories inside it. Every one of those payments crosses the border. The balance of payments is the record of all of them for one year. The record has three accounts, and they always add to zero: a country that spends more abroad than it earns must be receiving money from abroad to cover the gap. The exam asks you to read the record, add it up, and then judge whether a gap that will not go away is a problem. Where you meet it:
Paper 1
- Essays.
- Explain [10]: two consequences of a persistent current account deficit, or how fiscal policy narrows one.
- Discuss [15]: the implications of a persistent current account deficit.
Paper 2
- Data response, from a balance of payments table.
- Calculate [1 to 3]: the current account balance, the balance of trade in goods or in services, the change between two years.
- Define [2]: the balance of payments, the current account, portfolio investment, remittances, reserve assets.
- Explain [4]: how the accounts offset each other. State [1]: surplus or deficit.
The exchange rate
- The two move each other.
- A persistent deficit pushes the currency down; a persistent surplus pushes it up.
- A cheaper currency is one of the ways to close a deficit.
📒 Three accounts, one record
The balance of payments is a record of all economic transactions between the residents of a country and the rest of the world over a period of time, usually a year. Money coming in is a credit, money going out is a debit. Each transaction is filed in one of three accounts.
| Account | What is recorded | Example entries |
|---|---|---|
| Current account | trade in goods, trade in services, primary income, secondary income | cars exported, a holiday abroad, dividends paid to a foreign shareholder, remittances a nurse sends home |
| Capital account | one-off capital transfers; usually small | debt forgiveness, EU structural funds, the assets a migrant brings with them |
| Financial account | cross-border investment flows | foreign direct investment (a factory built abroad), portfolio investment (foreign shares and bonds), changes in the central bank's reserve assets |
Current account + capital account + financial account = 0. Every payment out is somebody's receipt in, so a deficit on one account is matched by a surplus on another. So the balance of payments is in deficit is never right. Say which account is in deficit: almost always the current account.
💰 How a deficit gets paid for
A current account deficit means the country's debits (imports, income paid out, transfers out) are bigger than its credits (exports, income earned, transfers in). It is spending more abroad than it earns abroad. The difference has to come from somewhere, and that somewhere is the financial account.
Current account deficit
- Imports and income paid out exceed exports and income earned. The country owes the rest of the world the difference.
Foreign money must come in
- The gap is paid for by foreigners buying the country's assets or lending to it.
Foreign direct investment
- A foreign firm builds a factory or buys a company. Long term and the most stable inflow.
Portfolio investment
- Foreigners buy the country's shares and government bonds. Quick to arrive and quick to leave.
Reserves fall
- If not enough comes in, the central bank sells its foreign currency reserves to cover the rest.
Financial account surplus
- Those inflows add up to a surplus that is the same size as the current account deficit. The record sums to zero.
Important: Portfolio investment: the purchase of foreign shares and bonds, where the buyer does not take control of the firm. It is on the financial account and it is more volatile than direct investment. Reserve assets: the foreign currency and gold held by the central bank, used to pay for a deficit or to hold up the exchange rate. Also on the financial account. Remittances are the one people misfile: money sent home by workers abroad is secondary income on the current account, not investment.
📉 Why a deficit appears
A deficit opens when imports rise faster than exports, or exports lose ground. Six causes come up. Use them to explain a deficit, never just to name one.
| Cause | Why the gap opens | Example |
|---|---|---|
| Strong domestic demand | a fast-growing economy buys more of everything, including imports | a boom year: more foreign cars and phones bought |
| Overvalued exchange rate | exports look expensive to foreigners, imports look cheap at home | a currency held too high makes the country's trainers dear abroad and Italian trainers cheap at home |
| High relative inflation | domestic prices rise faster than rivals' prices, so goods lose competitiveness | a 10% inflation rate against a 2% rate in the trading partner |
| Low productivity | domestic firms make less per worker, so they cannot match foreign prices or quality | an old car plant losing sales to a modern one abroad |
| Dependence on primary commodities | export earnings swing with world prices and add little value | a copper exporter when the copper price halves |
| High incomes | richer consumers spend a bigger share of each extra euro on imports | a wealthy country importing luxury goods |
Ask what is being imported. A country importing machines to build new factories is investing; the exports come later. A country importing consumer goods on borrowed money is not. Ask how long it has lasted and what is funding it. A short deficit funded by direct investment is fine. A deficit that lasts for years and is funded by short-term borrowing is the problem case.
💱 Persistent deficit, persistent surplus, and the currency
One year's gap is a detail. A gap that stays for years changes the country. A persistent deficit builds up debt and foreign ownership and pushes the currency down. A persistent surplus has costs too, and they are the mirror image.
Persistent current account deficit: **Rising foreign debt**: the gap is borrowed every year, and the interest on it is itself a debit next year.. **Depreciation pressure**: importers keep selling the currency to buy foreign goods, so its value falls.. **Loss of confidence**: if investors doubt the debt will be repaid, they pull out and the currency can crash.. **Falling reserves**: a central bank that defends the currency runs its reserves down..
Persistent current account surplus: **Appreciation pressure**: foreigners keep buying the currency to pay for exports, so its value rises and exports slowly lose competitiveness.. **Trading partners object**: a surplus kept going by an undervalued currency is seen as unfair, and invites tariffs.. **Under-consumption**: the country's own people are sending more abroad than they get back, so they live below what they produce.. **Somebody else's deficit**: every surplus is another country's deficit..
An overvalued currency causes a deficit. The deficit then pushes the currency down. And a cheaper currency helps to close the deficit, because exports get cheaper abroad and imports cost more at home. In a freely floating system that loop is the self-correction. It is slow, and while it runs the country is paying more for its imports, so inflation can rise.
🔧 Correcting a deficit
Three families of policy. Two work fast and cost something; the third fixes the cause but takes years. Every policy question turns on which family a measure belongs to.
| Family | What it does | Examples | The cost |
|---|---|---|---|
| Expenditure reducing | cuts total spending, so imports fall with it | higher taxes, lower government spending, higher interest rates | less output and more unemployment at home |
| Expenditure switching | moves spending away from imports towards home-made goods | a depreciation or devaluation, tariffs, quotas | imported inflation, retaliation from partners, slow to work |
| Supply-side | makes exports genuinely more competitive | education, research spending, infrastructure, cutting business regulation | takes years to show; nothing happens this year |
Important: Reducing shrinks the whole pie: people spend less on everything, imports included. Switching keeps the pie the same size and changes what it is spent on. A strong answer pairs a short-run measure from the first two with a supply-side measure for the long run, and names the cost of each.
🔢 Doing the sums
Every calculation in this topic is an addition with signs. The data table gives you the parts; you add them up and say what the answer means.
- current account balance: positive is a surplus, negative is a deficit
- balance of trade in goods: exports of goods minus imports of goods
- balance of trade in services: exports of services minus imports of services
- net primary income: wages, interest, dividends and profits earned from abroad minus those paid abroad
- net secondary income: remittances, aid and pensions received minus those sent out
From the table to the answer
- Write the formula — Current account = trade in goods + trade in services + net primary income + net secondary income. Writing it first shows the method even if a number slips.
- Fix the signs — Exports and money coming in are positive. Imports and money going out are negative. If the table already gives a net figure with a minus sign, keep the minus.
- Add up — Add every line, in the units the table uses (millions or billions). For a change between two years, work out each year's balance first, then subtract the earlier from the later.
- Name it — Negative is a deficit, positive is a surplus. Write the word and the unit: a deficit of 25 million dollars, not a bare −25.
Formula → signs → add → name it
Important: Adding imports instead of subtracting them. Filing remittances under services instead of secondary income. Leaving the answer as a number without saying deficit or surplus.
✍️ Worked examples
The four shapes this topic is asked in, with new scenarios. Try each before opening the plan.
A country's balance of payments for one year shows, in millions of dollars: exports of goods 640, imports of goods 720, exports of services 210, imports of services 160, net primary income −35, net secondary income +40. Calculate the current account balance.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
Now the short explanation.
A text reports that a country has run a current account deficit for the third year in a row. Explain how the other accounts of the balance of payments offset this deficit.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
Now the Paper 1 policy question.
Using a real-world example, explain how contractionary fiscal policy could reduce a current account deficit.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
And the essay.
Using real-world examples, discuss the implications of a persistent current account deficit for an economy.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
✅ Quick self-check
Tap each card to check yourself.
Define the balance of payments. A record of all economic transactions between the residents of a country and the rest of the world over a period of time, usually a year. Its three accounts add to zero.
Define portfolio investment. Which account is it on? The purchase of foreign shares and bonds without taking control of the firm. It is on the financial account and it is more volatile than direct investment.
Define remittances. Which account are they on? Money sent home by people working abroad. They are secondary income on the current account, not trade and not investment.
Define reserve assets. The foreign currency and gold held by the central bank, used to pay for a deficit or to support the exchange rate. Changes in them are recorded on the financial account.
The current account balance is −18, the goods balance is −60 and net primary plus secondary income is +12. What is the balance of trade in services? Services = current account − goods − income = −18 − (−60) − 12 = +30. A surplus of 30 on trade in services.
Year 1: exports 500, imports 530, net income +10. Year 2: exports 540, imports 600, net income +5. How did the current account change? Year 1: 500 − 530 + 10 = −20. Year 2: 540 − 600 + 5 = −55. The deficit widened by 35.
The current account is −40 and the capital account is +2. What is the financial account? The three add to zero, so the financial account is +38: a surplus of 38, money coming in to fund the deficit.
A tariff on imports and a rise in income tax both cut a deficit. Which family is each? The tariff is expenditure switching: it moves spending from imports to home-made goods. The tax rise is expenditure reducing: it cuts total spending, and imports fall with it.
Exam tips
- Keep the signs. Exports and money coming in are positive; imports and money going out are negative. A sign slip is the most common lost mark in the topic.
- Finish every Calculate with the word deficit or surplus and the unit. A bare negative number is an incomplete answer.
- The balance of payments always adds to zero, so it is never in deficit. Name the account: the current account is.
- Remittances are secondary income on the current account. Portfolio investment and reserve assets are on the financial account.
- A deficit is not automatically a problem. Say what would make it one: how long it has lasted, what is being imported, and what is funding it.
- Switching moves spending between imports and home-made goods; reducing cuts total spending. Say which family a policy is, then its cost.
- For a 15-mark essay, a real country on each side, and a verdict that names the condition, beats a list of six consequences.